Debt Debate Distracted From, Maybe Worsened, Real Threat: Recession

If the debt crisis was such a crisis, someone forgot to tell buyers of U.S. debt. In the last month, as debt threat hysteria reached a peak, the so-called yield curvecollapsed sending prices for the supposedly tainted securities surging and yields lower. The 2-year Treasury hit a record low yield of 0.32 percent on Tuesday, the 10-year touched an 8-month low of 2.6 percent and the 30-year dropped below the key 4 percent level to 3.89 percent.

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Politicians like Sen. Mitch McConnell (R) Ken. would have you believe this is because the debt agreement calls for a regular deficit check-up every time the debt ceiling needs to be raised, thus instilling credibility back into the Treasury market. But given the fact that bond buyers all but ignored this debate for months, investors and economists said the debate was all but a distraction as the country, and maybe even the globe, head for a recession.

The stock market finally caught on a week ago.

"Politicians and the media grossly misrepresented the real story to the public, choosing instead to focus on scaring people into believing the U.S. government would default on its debt," said Brian Jacobsen, Wells Fargo Funds Management chief portfolio strategist. "Despite all that, the markets knew better and moved lower on poor economic data instead of on the bad drama from Washington, D.C."

Bond buyers kept buying throughout the debate because even with a downgrade, they felt like U.S. treasuries were still the best safe haven against a recession, especially the long bond, which saw the biggest increase in price.

"Volume was heavy and across all investor types, especially real money who poured cash back into the Treasury market again," said William O'Donnell on the RBS bonds desk Tuesday. "We got the breakdown in S&P futures that we feared and that tells me to buy dips in Treasuries if there are any. The front end looks fully cooked, buy longer duration paper. Next target is 2.46% in 10-Year yields."

Meanwhile, the S&P 500 has fallen seven straight sessions for losses greater than 6 percent, its longest losing streak since the crisis of 2008. The S&P 500 has not had an official 10-percent correction since the bull market began back in March 2009.

"The growth statistics are horrible and the bond market is projecting that we are in another recession," said Alec Levine of New Edge. "Very few people are using the "R" word again, but the economy has stopped growing, in its tracks, and it looks like its more than just a blip on the radar."

The public got their first sign of what the bond market was signaling at the end of last week when second quarter GDP expanded only 1.3 percent, below the 1.8 percent expected. What was more troubling, however, was that first quarter growth was revised to just 0.4 percent and the 2008 and 2009 downturns were shown to be actually deeper than expected, according to government figures. Weak manufacturing and personal income data only added to fears of a retrenchment.

Some strategists said that the new two-step austerity plan agreed upon by Congress could make a recession even more likely and what's worse, tie the hands of the Fed to step in and help.

"Unfortunately, the specific structure of the bill just passed has led us to conclude that the bill for our past profligacy has finally come due, not because of outside market forces that have imposed fiscal discipline, but because of the new political realities in Washington," said Jason Trennert, head of Strategas Research Partners, in a note. " As a result, we are increasing our odds of a recession in 2012 to 35% (from 20%) and our odds of a recession in 2013 to 60% (from 50%)."

The Fed's hands may not be totally tied, according to Brian Kelly of Brian Kelly Capital. He pointed to a speech given by the Brian Sack, executive vice president of the Federal Reserve Bank of New York, on July 20, where he hinted the Fed could reinvest the proceeds from its $2.654 trillion portfolio into later maturities.

"The Fed will extend maturity of its balance sheet by reinvesting in 30-year paper," said Kelly.

This would keep long-term rates low in an attempt to avoid a recession. Of course, it likely would keep a bid under bonds as well.

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